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Integrative Case 4.doc

Integrative Case 4: OGrady Apparel Company OGrady Apparel Company was founded nearly 160 years
ago when an Irish merchant named Garrett OGrady landed in Los Angeles with an inventory of heavy
canvas, which he hoped to sell for tents and wagon covers to miners headed for the California goldfields.
Instead, he turned to the sale of harder- wearing clothing. Today, OGrady Apparel Company is a small
manufacturer of fabrics and clothing whose stock is traded on the over- the-counter exchange. In 2006,
the Los Angeles based company experienced sharp increases in both domestic and European markets
resulting in record earnings. Sales rose from $ 15.9 million in 2005 to $ 18.3 million in 2006 with earnings
per share of $ 3.28 and $ 3.84, respectively. European sales represented 29% of total sales in 2006, up
from 24% the year before and only 3% in 2001, 1 year after foreign operations were launched. Although
foreign sales represent nearly one- third of total sales, the growth in the domestic market is expected to
affect the company most markedly. Management expects sales to surpass $ 21 million in 2007, and
earnings per share are expected to rise to $ 4.40. ( Selected income statement items are presented in
Table 1.)
Table 1. Selected Income Statement Items
2004 2005 2006 Projected 2007
Net sales $ 13,860,000 $ 15,940,000 $ 18,330,000 $ 21,080,000
Net profits after taxes 1,520,000 1,750,000 2,020,000 2,323,000
Earnings per share ( EPS) 2.88 3.28 3.84 4.40
Dividends per share 1.15 1.31 1.54 1.76
Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned that available
funds are not being used to their fullest potential. The projected $ 1,300,000 of internally generated 2007
funds is expected to be insufficient to meet the companys expansion needs. Management has set a
policy of maintaining the current capital structure proportions of 25% long- term debt, 10% preferred
stock, and 65% common stock equity for at least the next 3 years. In addition, it plans to continue paying
out 40% of its earnings as dividends. Total capital expenditures are yet to be determined.
Jennings has been presented with several competing investment opportunities by division and product
managers. However, because funds are limited, choices of which projects to accept must be made. The
investment opportunities schedule ( IOS) is shown in Table 2. To analyze the effect of the increased
financing requirements on the weighted average cost of capital ( WACC), Jennings contacted a leading
investment banking firm that provided the financing cost data given in Table 3. OGrady is in the 40% tax
bracket.
Investment Opportunities Schedule ( IOS)
Investment opportunity Internal rate of return ( IRR) Initial investment
A 21% $ 400,000
B 19 200,000
C 24 700,000
D 27 500,000
E 18 300,000
F 22 600,000
G 17 500,000
Financing Cost Data Long- term debt: The firm can raise $ 700,000 of additional debt by selling 10- year,
$ 1,000, 12% annual interest rate bonds to net $ 970 after flotation costs. Any debt in excess of $ 700,000
will have a before- tax cost, kd, of 18%.
Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $ 60 par value and
a 17% annual dividend rate. It will net $ 57 per share after flotation costs.
Common stock equity: The firm expects its dividends and earnings to continue to grow at a constant rate
of 15% per year. The firms stock is currently selling for $ 20 per share. The firm expects to have $
1,300,000 of available retained earnings. Once the retained earnings has been exhausted, the firm can
raise additional funds by selling new common stock, netting $ 16 per share after under- pricing and
flotation costs.
1. Over the relevant ranges noted in the following table, calculate the after- tax cost of each source of
financing needed to complete the table.
Source of capital Range of new financing After- tax cost (%)
Long- term debt $ 0$ 700,000 ___
$ 700,000 and above ___
Preferred stock $ 0 and above ___

Common stock equity $ 0$ 1,300,000 ___
$ 1,300,000 and above ___
2. a. Determine the break points associated with each source of capital. b. Using the break points
developed in part ( 1), determine each of the ranges of total new financing over which the firms weighted
average cost of capital ( WACC) remains constant. c. Calculate the weighted average cost of capital for
each range of total new financing.
3. a. Using your findings in part b( 3) with the investment opportunities schedule ( IOS), draw the firms
weighted marginal cost of capital ( WMCC) schedule and the IOS on the same set of axes, with total new
financing or investment on the x axis and weighted average cost of capital and IRR on the y axis. b.
Which, if any, of the available investments would you recommend that the firm accept? Explain your
answer.
4. a. Assuming that the specific financing costs do not change, what effect would a shift to a more highly
leveraged capital structure consisting of 50% long- term debt, 10% preferred stock, and 40% common
stock have on your previous findings? ( Note: Rework parts b and c using these capital structure weights.)
b. Which capital structure the original one or this one seems better? Why?
5. a. What type of dividend policy does the firm appear to employ? Does it seem appropriate given the
firms recent growth in sales and profits and given its current investment opportunities? b. Would you
recommend an alternative dividend policy? Explain. How would this policy affect the investments
recommended in part c( 2)?

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